The Latest news from the Motley Foot: Can today's high-flyer keep climbing?

Saturday 12 June 1999 23:02 BST

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At Motley Fool we like to encourage people to buy companies that they know and like, but that is just the beginning. You should be careful to understand the valuations of your favourite companies before you part with any cash.

Let's have a look at a share very much in vogue - Vodafone. The UK is awash with mobile phones and Vodafone has 37 per cent of the market. The company released results this week, and they are a good example for anyone considering investing in the telecoms sector.

Vodafone's profits before tax were up an impressive 44 per cent from last year, with earnings per share (that is the amount of profit left over for each share, after all outgoings) growing by 51 per cent. That sounds great, but it is important to look at the reasons behind this growth, where future growth is likely to come from, and how much of the expected growth is already included in the share price.

A common indicator of the expected future value of a company's shares is its price-to-earnings ratio, or p/e for short (but Foolish investors are warned that the p/e on its own does not provide enough information to make a decision). The p/e is the current share price divided by the company's current earnings per share, and it shows how many years of such earnings would be needed to cover the company's current valuation. Good growth in earnings will feed through to an increase in share price, we hope, so a company with high expected future growth will usually have a higher p/e than a company that expects lower growth.

At the current share price, Vodafone's p/e is a little over 60. It would, therefore, take more than 60 years of earnings to pay back the company's current valuation. Investors are clearly expecting some serious growth in earnings, so we need to think about where that growth will come from.

Vodafone's growth this year has been driven by a huge rise in the number of customers worldwide. There are now 10.4 million users, with 5.6 million in the UK alone. Almost one in 10 of the UK population has a Vodafone phone. The total penetration of mobile phones in the UK at the moment is approximately 25 per cent of the population, with Cellnet coming in a close second with 1 million fewer customers.

This year's growth in mobile phone usage has been driven by the introduction of pre-paid phones. These free people from the commitment of long-term contracts. A mobile phone can be much more desirable if you don't have to pay anything when you are not using it.

Another interesting area of growth has been in text messaging, which is useful and has a cult following among teenagers.

So where is the future growth going to come from? It is clear that market penetration in the UK cannot continue at the current rate for much longer. There is, after all, only a finite number of people who will ever own a mobile phone. That 25 per cent penetration is 25 per cent of the whole population, and there are plenty of people who are never going to buy a phone - children, older people, people who cannot justify the cost, and those who simply hate the things.

A lot of the future growth is expected to come from overseas, and Vodafone's acquisition of AirTouch in the USA is a big step in that direction. Bell Atlantic's intention to break its strategic alliance with AirTouch (they previously agreed to take one American coast each and not compete in each other's backyards) might not be great news on this front, but in the longer term it does open up greater competition, and should favour the more efficient of the two companies.

The decision to invest in a telephone company, whether it is Vodafone or a competitor, is, like all investment decisions, a personal one.

Do you think your chosen company will grow, for long enough, at a rate that justifies its current p/e valuation? Is it the best in its sector? The Fool's advice is to conduct your own research, ask lots of questions, ponder the answers carefully, and make your own decision.

Motley Fool, www.fool.co.uk

ASK THE FOOL

Burmah Castrol has just carried out a share buy-back. Where I previously had 359 shares, I now have 299 shares and pounds 472. The thing that interests me, however, is that the shares were originally of a nominal value of pounds 1. On the new share certificate it states that my original holding was 359 shares of nominal value 35p, while the new shares are of nominal value 42p. Why the change from pounds 1 to 35p?

BW, Kent

The Fool responds: The Burmah Castrol restructuring was complex. After the various capital changes, for every six old nominal pounds 1 shares, you will have received five new nominal 42p shares plus 786p in cash. This explains why your shareholding was reduced from 359 to 299 shares and the fact that you received pounds 472 in cash.

However there were (complex) intermediate steps, in which each old pounds 1 nominal ordinary share was first split into one new 35p nominal ordinary share and one new 65p nominal special capital share worth approximately 131p. Those capital shares were then cancelled in return for the cash, and the new ordinary shares were split 6 for 5, thus making the new nominal value 42p instead of 35p.

WHEN the Aids scare first hit the UK, safe sex was all the rage, hence the popularity of condoms. The London Industrial Group (or the London Rubber Co as it used to be) seemed a good bet. With limited funds I invested pounds 200 in shares. I am not sure of the time scale but within three or four months my money had doubled. I seem to recall that on one day alone the shares increased by 45 or 50p. If only I had had pounds 20,000 to invest!

JE, Kent

The Fool responds: A bit of lateral thinking can often pay off handsomely. But the Fool's advice would be to always follow it up with some company research, and we certainly wouldn't recommend risking your whole savings on just a single company!

Send us your smartest or dumbest investment story. If we publish it, you'll get a free copy of the 'Motley Fool UK Investment Guide'. E-mail to UKColumn @fool.com or snail mail to Motley Fool, 79 Baker Street, London W1M 1AJ.

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